Article by: Jeff Skolnick, CPA, M.S. Taxation
Although there has been much said about the drop in the corporate income tax rate, there are many reasons why a shareholder may want to convert a C corporation into an S corporation.
Let me start out be explaining a little about the differences between a C corporation and an S corporation. While both C and S are both considered corporations entitled to the same legal liability protection, the main difference is the way each is taxed. A C corporation is taxed on its own income. An S corporation is considered a “flow through” entity. The income generated by the S corporation is not taxed at the corporate level, it is passed to its shareholders and reported on their income tax returns.
Prior to 2018 corporate income tax rates varied from 15% to 35%. The Tax Cut and Jobs Act passed in 2017 reduced the corporate income tax rate to a flat 21% on all corporate income. Previously the first $50,000 was taxed at 15% and the percentage increased to 25%, 34% etc. Based on the graduated rates prior to 2018 and the new 21% flat tax, any corporation with taxable income greater than $90,385 will pay lower taxes. This is the reason you are hearing more buzz about C corporations which prior to the new law were largely being replaced by S corporations. S corporations stands for small business corporation which at one time was limited to 35 shareholders but over the years has been expanded to 100 shareholders. There are also restrictions on who may be a shareholder (must generally be an individual, estate or certain trusts and cannot be a nonresident of the US). C corporations have no limit to the number of shareholders. S corporations also have restrictions pertaining to stock issued but here I am going to concentrate on the income tax differences.
I feel the best way to explain the differences in tax treatment between these two entities is by example. Our corporation for this example has 1 owner, Kathy. Additionally, I will only address the federal income tax liability of the corporation and shareholder although both may be subject to state and city jurisdictions as well. Let’s say the corporation which after paying all expenses including Kathy’s wages has a taxable income of $100,000 and a cash balance of $100,000.
The first case will be that of a C corporation. The C corporation as mentioned earlier will be taxed at 21%. In this example the corporation will pay $21,000 of Federal income tax. This leaves $79,000 in the company. If the company distributes this money to the shareholder, it is considered a dividend. The corporation gets no deduction for this and the shareholder pays income tax on this money at their long-term capital gains rate (0%, 15% or 20% depending on taxable income). For our example I’ll choose the middle of the road 15%. In our example Kathy would receive $79,000 and pay a tax of $11,850. Realize at this point that both the corporation and the shareholder paid tax on the same money. This is where the term double taxation on corporate income comes from. The corporation and Kathy paid a total of $32,850 on the $100,000 taxable income of the corporation.
If Kathy’s corporation is an S corporation, then there is no tax at the corporate level. The $100,000 is taxed only on Kathy’s return. Let’s assume Kathy is married and has taxable income less than $321,450 (including the $100,000 from the S corporation) in 2019. In this case her tax rate would be 24%. Kathy would pay $24,000 of tax on the $100,000 earned by her S corporation. Here’s the cool part when the S corporation distributes $100,000 to Kathy, she pays no income tax on it because she was already taxed on that money. Kathy’s income tax rate although higher than the corporate rate still yielded a lower tax because of the double taxation aspect of a C corporation. In this case Kathy has paid tax of $24,000 and still has $76,000. In the prior example a total tax of $32,850 was paid meaning the balance left was $67,150 or $8,850 less.
Another point I’d like to make here is that it is also possible in some instances to have a net taxable loss in your corporation. If this occurs in a C corporation, the tax is $0 for the year and the loss is carried forward to reduce income in future years. If the corporation is an S corporation, the loss may be deductible on the shareholder’s return. I say may be deductible because there are some conditions that must be met, and that discussion is beyond the scope of this writing. Lastly, unlike partnership income, income from an S corporation is not subject to self-employment tax (which can be approximately 14.1%).
Now that I’ve explained why a shareholder may want to convert their C corporation to an S corporation, I will explain how this is done and some things traps to avoid.
If you would like to convert your C corporation into an S corporation. You simply must file Form 2553, which is a simple form. The most important aspect of filing this form is to have all the shareholders sign the Form and it is be mailed to the Internal Revenue Service. This can generally be done any time prior to the year you would like to change or by the 15th day of the third month in the year of change. In other words, if you would like to become an S corporation as of January 1, 2020. You can file any time prior to January 1, 2020 or by March 15, 2020.
S corporations do have certain rules and regulations that must be met. I already mentioned some of the restrictions on stock ownership. Additionally, an S corporation can have only 1 class of stock (not usually a problem for small businesses), must have a calendar year end in almost all cases, and any distributions made to shareholders must be ratable. For example, if an 80% owner takes an $8,000 distribution a 20% owner must receive a $2,000 distribution at the same time.
A shareholder of a C corporation that has his/her health insurance paid the corporation is treated the same as any other employee. This means a health insurance deduction by the corporation with the shareholder picking up no income. An S corporation shareholder that owns 2% or less of the S corporation is treated in the same manner as a shareholder of a C corporation. An S corporation shareholder that owns more than 2% must add the health insurance paid on their behalf as well as that paid on behalf of their spouse and dependents to their wages. This additional wages are not subject to Social Security, Medicare or Federal unemployment taxes, however in order to receive a deduction on their personal tax return (which would offset the wages added to the W-2) the shareholder must have social security wages from the business (aside from the wages added not subject to federal payroll taxes). For example, if the taxpayer had $18,000 added to his/her wages they would require at least $18,000 of wages from the S corporation not counting the health insurance addback.
There are two additional items to be aware of when you convert a C corporation to an S corporation. Neither of these problems exist if an S corporation was never a C corporation.
The first is something called the built-in gains tax. While normally an S corporation has no Federal income tax the built-in gains tax is an exception. This tax occurs when a C corporation has appreciated property and becomes an S corporation. Remember earlier in our example when the C corporation made a profit there was a double tax upon distribution to a shareholder, but none if the corporation was an S corporation? Let’s say a C corporation has a building with a cost basis of $100,000 and a fair market value of $200,000. The shareholder converts to an S corporation to avoid the double taxation on this building when it’s sold. The law states that unless the S corporation retains the building for at least 5 years it would have to pay tax on it at the highest corporate level (currently 21%). Once 5 years pass an S corporation can sell the building and there is no double taxation.
The second item has to do with corporations that have “Accumulated earning and profits” as a C corporation. Accumulated earnings and profits would be best illustrated with another example. Let’s go back to our original example where the corporation made $100,000 of taxable income and paid $21,000 of tax. When the corporation distributed the remaining $79,000 to the shareholder, that shareholder incurred an additional income tax of $11,850. Let’s say the corporation did not distribute this $79,000 and became an S corporation. This $79,000 is considered accumulated earnings and profit. If you own an S corporation with accumulated earnings and profit from it’s time as a C corporation and the corporation receives more than 25% of its income from passive sources (such as interest income, dividend income or rental income) for 3 straight years, then the S election will be terminated. The government wants you to distribute those earnings so they can tax the shareholder. The termination can be avoided by making an election to distribute the earnings and profits.
As you can see there are significant tax reasons to switch from a C corporation to an S corporation but there are also specific steps to be performed by certain dates. Furthermore, there are a variety of regulations that must be monitored in order to assure that you don’t accidentally terminate your S corporation. It is because of these factors that I urge you, as always, to consult with a tax professional well versed in this area of the law before converting your C corporation to an S corporation.
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